The Terrors of Tinseltown

Think the VCR scared the motion picture industry? Peer-to-peer file-sharing, which enables users to swap digital content, could cut the major studios out of the distribution loop. Here's a look at the CFOs behind the Napsterization of Hollywood.

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Prologue

Back in 1978, at the tender age of 24, I moved to Hollywood. I was an actor, you see, full of youthful bravado and convinced I was on a fast track to stardom. I had just wrapped the movie Meatballs, with Bill Murray, in which I co-starred as Crockett, the summer camp counselor with the big hair and cute girlfriend. The comedy, which wasn’t expected to do much business, turned out to be a sensation, raking in some $100 million in box office receipts — on a paltry $2 million in production costs.

Not surprisingly, I was suddenly hot property in Hollywood. My agent flaunted me all over town, billing me as the next big thing. Within weeks, I landed a gig with Norman Lear, then the hottest TV producer in show business, who signed me to star with former Brady Buncher Christopher Knight in a new sitcom, Joe’s World. NBC, banking on Lear’s magic touch, eagerly snapped up the first 13 episodes. The pilot went over like gangbusters, finishing in the top 10 of the Nielsen ratings. By that point, I was convinced it was only a matter of time before I was sticking my shoes in wet cement at Mann’s Chinese Theater.

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Then, suddenly, inexplicably, my acting career hit a brick wall. In 1980, after weeks of declining ratings, NBC canceled my show. I didn’t even get a phone call from the producer telling me the bad news — I read about it in the paper (“I Lost My Job in the L.A. Times”). Soon, my agent was having trouble getting me in to see producers. I couldn’t even get an audition for a commercial for a used car lot — and I’d bought my car there. Out of work, I packed my things and moved back to New York. My days as a Hollywood up-and-comer were over-and-out. Like the man says, there are no second acts.

When all this happened, I couldn’t really make sense of it. All I knew was that in two short years, I had appeared in a hit movie, starred in a sitcom, and been summarily tossed out on my ear. Years later, it dawned on me just how powerless I was. The harsh truth is Hollywood is its own gravitational field — a glittering galaxy owned, operated, and marketed by the major entertainment studios. Granted, most of the studios are public companies. But in reality, the film industry is more monolith than governance. It’s a crank-’em-out celluloid machine — a machine controlled by some extremely powerful people.

To many studio executives and big-name producers, that power will never be threatened, never usurped. To these industry titans, the real business of show business — the marketing and distribution of motion pictures — will never change. In their minds, the movie business is a very private affair, which may explain the huge gates at the entrances to studio lots. The message is clear: Enter at your own risk.

Litigated to Death

Tell it to Travis Kalanick. Kalanick, co-founder and finance head of Scour Inc., can best be described as a new-media revolutionary. In 1997, he and four other UCLA computer science students started Scour, a search engine and file-swapping software that made it ridiculously easy to share movies online — without paying Hollywood a cent.

Alarmed by the exploding popularity of Scour, the entertainment industry marshaled its forces. In 2000, the Motion Picture Association of America (www.mpaa.org) and others filed a $250 billion lawsuit against the company for copyright infringement. Even the reputation of super-agent Michael Ovitz, an investor in Scour, failed to sway the MPAA from its legal course. Unable to fund a defense, the startup teetered, then went bankrupt. In December, management eventually sold its remaining assets to CenterSpan Communications Corp. (www.centerspan.com). Says Kalanick bitterly: “We were litigated to death.”

Hollywood’s litigiousness is not hard to fathom. Virtual sharing of films — from one personal computer to another — threatens the entire film industry. At the top of the endangered species list: the major studios, which would effectively be cut out of the loop by cyber-swapping of movies. After all, what more perfect distribution medium for a digital product than a digital highway?

Studio heads can already see what unauthorized file-swapping has done to cash flow at music companies. The numbers are staggering. The Recording Industry Association of America (www.riaa.com) reported that shipments of CD singles fell by nearly 40 percent last year. A music industry spokesperson says the drop in singles sales was “principally brought on by new options provided by the Internet.”

Further, many people in the film business honestly believe peer-to-peer (P2P) technology is little more than a license to steal. “[These sites] profess to defend technological advancement, but in truth treat copyright with a brazen disdain for laws and rules,” says MPAA president and CEO Jack Valenti. “The bottom line is that people are stealing movies on these sites that they do not possess or have not paid for.”

Kalanick vehemently disagrees. “Scour was no more an illegal device than your VCR is, or a Xerox machine is,” he says. “If Scour users broke the law by sending copyrighted files, then they’re the ones who should have been sued — not us. You arrest the burglar, not the company that made the burglar’s tools.”

Litigate or Lunch?

The jails would be full up. According to the latest estimates, 12 million copies of Project Mayo (www.projectmayo.com) have been downloaded from the Internet. Project Mayo, which is based on something annoyingly called DivX 😉 technology, enables users to freely exchange illegal copies of movies over the Internet. Some industry watchers reckon that, with Project Mayo, Gnutella, and other peer-to-peer file-exchange software in cyberspace, 400,000 movies are swapped on the Net every day.

And that’s just the beginning. P2P networking (PCs sharing data via the Net, without a central server) is radical, paradigm-altering stuff. While some observers believe serverless networking will eventually make E-marketplaces obsolete, the entertainment business is under siege now.

Don’t let the recent court decision on Napster fool you. “The importance of the Napster decision lies in what it does not address and cannot prevent,” says Michael Graham, an intellectual property lawyer at Marshall, O’Toole, Gerstein, Murry & Borun. “Even if the Napster site is shut down, there are other sites and other software that enable the rapid sharing of computer files between distant computers. Stopping Napster does not stop file-sharing.” Adds attorney Steve Lesavich of McDonnell Boehnen Hulbert & Berghoff: “Peer-to-peer technology is here to stay.”

In Hollywood, the Huns are already banging on the studio gates. Digital entertainment specialist SightSound Technologies Inc. (www.sightsound.com) recently released the first movie made expressly for distribution over the Net. CFO Alex LePore says he is currently trying to secure more funding for the company. Another upstart, AtomFilms (www.atomfilms.com), renamed Atomshockwave after being bought by Shockwave Inc., uses P2P technology to distribute independent movie shorts and animation, including the wildly popular The New Arrival. According to CFO Eric Cansler, revenues at the company jumped 1,200 percent last year.

Whiz kid Gene Kan, a brilliant, 24-year-old Gnutella software maven, has also advanced the cause of P2P file-sharing. Last year, Kan created a UNIX version of the Gnutella file-sharing software — and has since become the unofficial spokesman for the P2P movement. Kan’s idea — and the idea behind most peer-to-peer networks — is simple. Rather than place huge files of digitized entertainment on a massive server, the files are stored on the individual hard drives of thousands of PCs. That way, bandwidth is shared by everyone. Conversely, in a typical video-on-demand (VOD) setup — the Net distribution model most studios are pursuing — you need pipes the size of the Holland Tunnel to distribute movies.

Ironically, the P2P evangelists say they’d happily license their swell file-swapping technology to motion picture studios, with artists and studios getting their fair share of the profits. There’s only one problem: For the moment, it appears the studios would rather litigate than lunch.

It’s a familiar script. Indeed, if the legal wrangling to stop P2P movie sharing were a movie, it’d be a remake. Several of the same studios that filed suit against Scour also sued Sony and its Betamax VCR in the late 1970s. That case eventually reached the US Supreme Court, which ruled that the VCR offered too many benefits, such as watching home movies, to be banned. The parallels are frightening. “If we had the funds to take this to the Supreme Court, there’s no question in my mind we would have been vindicated,” Kalanick says, noting that Scour was predominantly used to swap noncopyrighted files — including home movies.

At P2P specialist Angry Coffee Inc. (www.angrycoffee.com), CEO Adam Powell was so nervous about possible litigation that he pulled the switch on the company’s much-trumpeted file-sharing service, Percolator, before any files were swapped. “After what happened to Scour, we decided not to have the company hanging by some judge’s decision,” Powell recalls. “We didn’t want to incur the MPAA’s wrath in the form of litigation.” Adds Todd Choy, the company’s interim CFO: “We wanted to take the high road, to send a message that we want to work with the industry long term.”

Pic Bigs Nix Vid Vig?

The industry seems to have its own plans. In many circles, the Net is seen as the next big distribution channel for studio-backed movies. According to Forrester Research, online delivery of films will account for 20 percent of motion picture revenues by 2003. Given that the industry took in $77 billion in exhibited movie revenues and $20 billion in rented or sold videos and DVDs last year, that’s a $20 billion cash stream.

But it’s not revenues that make executives at the six major studios (Paramount, Warner Brothers, Universal, Disney, Sony, and 20th Century Fox) sit up and take notice. It’s the unparalleled profit margins that come with virtual channeling. “There’s no videotape store or movie theater chain carving out a chunk of the distribution dollars,” notes Eric Scheirer, an analyst at Forrester. Blockbuster, for instance, takes a 50 percent cut for distributing videos and DVDs for the studios. As Scheirer says, “The motion picture industry would obviously prefer to keep more of this money.”

Toward that end, Hollywood is looking to do a little disintermediation of its own. The MPAA confirms that the major studios plan to unveil movies on the Net once they have content encryption, watermarking, and digital rights management procedures in place.

While representatives from the six studios declined to be interviewed for this article, the MPAA’s Valenti says: “I can tell you that several major studios will be online in four to six months, and have been testing various business models around the country.” He predicts most major studios will offer their movies over the Net by year-end, with smaller companies at their heels: “We would be fiscally insane not to use this magnificent delivery system.”

Asked if the studios would use a P2P delivery model, Valenti laughed. “The whole idea of file-sharing is absurd,” he says, noting that there are already millions of homes and sites at colleges and offices with broadband access. “These numbers will only increase.”

Kalanick goes further. He claims the co-location, data center-to-PC technology the studios are backing is, in fact, cost-prohibitive. “In the Co-location model, if you deliver 10 million movies a month, each at 3,500 megabytes, the monthly cost for bandwidth would be $16,203,740,” he explains. “Delivering the same content in a P2P model would cost $162,037 a month. The financial difference is tremendous.”

Waiting for the Rewrite

If Kalanick’s math is right, why isn’t Hollywood interested in P2P technology? “Because they didn’t create it,” Kan argues. Rather than do business with the inventors of promising technology, critics say the movie studios want to stop it dead in its tracks. The massive — often unauthorized — swapping of music files via Napster hasn’t exactly eased fears in Tinseltown. “Another factor,” says Kan, “has been that media concerns have been slow to decide upon and champion DRM-enabled formats.” (DRM is short for digital rights management.)

But some analysts argue that the major motion picture studios are simply biding their time, waiting for a clear-cut winner to emerge from the P2P pack. “The studios seem happy to have [companies like Scour and Angry Coffee] improve the technology and business models through trial and error, and then move forward,” asserts Scheirer of Forrester. “Is that fair? It’s business.”

Staying in business could prove a monumental task for many of these P2P upstarts. The Internet generation — a generation raised on free MP3 downloads — may not be willing to shell out for online entertainment. A recent poll of juror pools by the National Law Journal revealed that almost half the jurors said there was nothing wrong with downloading or sharing digital movies or music for free — without compensating the creators or distributors of the product.

But P2P backers remain convinced of the profitability of peer-to-peer entertainment. “There are all sorts of ways to monetize the experience,” Atomshockwave CFO Cansler insists, “from advertising to pay-per-view to fees based on the quality and speed of the download.” The Seattle-based company makes money from advertising and sponsorship, not pay-per-view. “Our content is monetized via a splash commercial — a 15-second advertisement appearing at the beginning of the film,” explains Cansler.

SightSound, on the other hand, employs a pay-as-you-go model. The site’s main attraction is the animated comedy South Park, which customers download by using an Internet connection. The site also boasts the first feature created exclusively for the Net, appropriately called Quantum Project. The 36-minute film, which was made for $3 million, stars John Cleese of Monty Python fame. Viewers who want to watch the movie using Gnutella are whisked to SightSound’s billing site, where they must pay $3.95 by credit card before opening the file.

But some observers believe Angry Coffee’s Percolator model holds the most promise. Why? Because it directly involves the movie studios. A Percolator user will be licensed by a studio to store a movie in his or her computer. Each time the movie is downloaded, that host will receive a commission paid by the studio that owns the film. Meanwhile, the person downloading the film — the other peer — will pay a fee to the studio by using a credit card. Obviously, the fee paid to the storer of the movie will be less than the fee paid by the downloader. “We have a sustainable revenue model that is long term and able to make a significant profit for the studios,” interim CFO Choy claims.

Long term is the key. Getting the capital to keep these “intertainment” companies afloat won’t be easy. Choy says Angry Coffee is in talks with “a major international entertainment company” to provide money to distribute products over Percolator. Atomshockwave has rounded up $28 million in two venture capital rounds so far. And SightSound completed a $17 million financing round in 1999 (as of press time, a deal to raise another $10 million in venture capital had not closed). But like other dotcoms, SightSound shelved a planned IPO because of economic conditions. “We’re pursuing alternative ways of funding our operations,” says LePore, who declines to elaborate.

Given the cash crunch, avoiding litigation is an absolute must. “And you do that,” Scheirer points out, “by convincing Hollywood that you’re a bunch of nice guys.”

A Neighborhood the Size of Cleveland

That may take some doing. As of now, the only way to watch full-length movies on the Web is to use Gnutella P2P software. The MPAA’s Valenti insists such an act is illegal.

Kan disagrees. He argues that sharing movies over the Internet is no different — or less moral — than crossing the street and lending a neighbor your copy of The Lion King. “Why does Hollywood turn its back when you rent or buy a film and invite friends over to watch it, but is intent on creating boundaries when it comes to Internet sharing of that film?” Kan asks.

The answer is obvious. P2P technology enables one person to walk across thousands of streets and share with thousands of neighbors. “It’s a question of scalability,” notes Mark A. Fischer, a copyright law expert and partner at law firm Palmer & Dodge LLC. “The occasional act of copying a music tape or videotape may be what the law allows for in what is called ‘fair use.’ This breaks down when you’re talking thousands — if not millions — of copies.”

But Kan argues that “only 5 percent of the world is online. And not many of those who are online use any file-sharing service.” Nevertheless, even Kan seems to understand the entertainment industry’s concern about P2P file-swapping. “The Internet creates a totally fluid sharing experience,” he grants. “By making sharing so easy, it has sounded alarms over its legitimacy.”

It also tends to make a mockery of intellectual property. “Copyright law encourages creativity by giving economic incentive to the creators to create,” Fischer says. “Without it, society as a whole suffers.”

Whether Hollywood suffers remains to be seen. But make no mistake, if the film industry gets Napsterized, if it loses substantial revenues to digital disintermediaries, heads will roll at the major studios. This scenario may explain some of the vitriol coming out of La La Land of late. For his part, copyright expert Fischer stops short of condemning the new-media revolutionaries: “Frankly, all but the most vicious critics of Scour and its workers recognize the brilliance of their technology, their intelligence, and their energy.” He also believes these terrors of Tinseltown play an important role, breaking uncertain ground despite the risk. “One could have wished for a more graceful process, however,” he adds.

Back at Angry Coffee, Adam Powell wonders about the process, as well. For now, he’s got his hands full steering clear of the Hollywood legal juggernaut. “We want to do this by the book,” Powell says. He pauses, as if contemplating the sword of Damocles that seems to be hanging above the heads of all the new-media revolutionaries. “It’s a chess game,” he says. “And believe me, you have to make moves very carefully or your king will get put to checkmate.”

Epilogue

In late February, weeks after I turned in this story, Bertelsmann eCommerce Group president and CEO Andreas Schmidt held a press conference. Bertelsmann (www.bertelsmann.com), you may recall, signed a partnership with Napster in October — an act that was seen as high treason by some record company executives, pure idiocy by others.

At the press conference, however, Schmidt dropped something of a bombshell. He revealed that, by selling music digitally over Napster, rather than selling compact discs, Bertelsmann could save at least $2.40 per CD. Typically, record labels net only about 35 cents profit for each compact disc they sell. By switching to music delivery over Napster, Schmidt noted that the company would have almost no additional costs — but would have additional revenues coming in. “If we switch,” he said, “all these delivery costs, all these distribution costs, they go away.”

It turns out Travis Kalanick’s math may have been right after all.

Russ Banham is a contributor to eCFO.

Dawn of the Killer App

The heads of the major studios may not be wild about P2P delivery of motion pictures, but that doesn’t mean they’re dead set against online movies. Far from it. While most of the big players have kept their Net plans under wraps, industry insiders say the studio heads view virtual delivery of films as the next great window (channel).

Nobody knows when they’ll open the window, however — not even the studios. Although an industry spokesman says several major entertainment companies are set to launch Internet initiatives by this summer, such a timetable may be optimistic.

Warner Brothers (www.warnerbros.co m), part of the AOL Time Warner franchise, is said to be digitizing its film archives, making it possible to distribute the company’s movies online. There appears to be no definite ETA for this, however. Sony Pictures (www.sonypictures.com) has announced a video-on-demand (VOD) project called MovieFly, which may offer movie rentals over the Web — in the near future. Disney (www.disney.go. com) is also reportedly developing a Net-based VOD strategy. Initially, it was thought the plan might involve the company’s Go.com Web site. But that’s doubtful — Disney recently pulled the plug on Go.com. Word is that Net division of Fox (www.foxmovies.com) is currently in discussions with Disney about a joint VOD strategy, although this cannot be confirmed. The new owner of Universal Studios (www.universalstudios.com), the French company Vivendi, holds a big stake in several cable systems. Those holdings could give Universal a leg up in delivering video-on-demand.

Cable modems, digital subscriber lines, and other high-speed highways aren’t the only routes to the local Internet drive-in. iBlast (www.iblast.com), a Los Angeles-based network representing 246 local television stations around the country, wants to bring movies to PCs the old-fashioned way: through the airwaves.

This wireless data broadcasting network beams to more than 93 percent of the continental US, with transmission towers aimed at PCs, set-top digital boxes, PowerVR platforms, and other receiving devices. Although the company is still testing the technology, iBlast’s management hopes the major studios will tap it as another virtual distribution channel. “We can send their stuff at the speed of lightning, with the same quality as network TV,” says Michael Lambert, iBlast cofounder and CEO.

Lambert, former president of domestic television at 20th Century Fox and one-time head of HBO’s home video distribution company, says iBlast is 200 times faster than the standard dial-up Internet connection. It can transmit up to 26,000 songs or 30 full-length movies a day, albeit just one way. “We distribute what we distribute — you can’t decide [which movie you want to see],” he explains. Lambert believes iBlast will also help soothe industry worries over piracy. The service will be so cheap, he claims, there will be little incentive for pirates to copy and circulate movies. “We make it more efficient for us to send a film to you than for you to send it to your neighbor.”

No content providers have jumped on board yet, although Lambert is in talks about the project with several movie studios. Working capital shouldn’t be a problem, though — he’s raised $40 million from major broadcast groups, including Tribune Co., Gannett, and Cox Communications. Crows Lambert: “We’re in the right place at the right time.” —R.B.

Future Shock

For proof of the growing corporate interest in peer-to-peer networking, consider the conference conducted in late February and early March. The symposium was sponsored by Intel (www.intel.com) — a chip maker, mind you, not a software vendor. The topic of the meeting? Developing standards for P2P networking.

Obviously, it’s not likely Intel is interested in peer-to-peer exchange because the company wants a piece of the Limp Bizkit MP3 action. No, observers say that managers at Intel see what other managers at other technology giants see: With industry standards for security and privacy in place, P2P networking will be ready for the big time.

Wide-scale corporate adoption may be only a few years off. At the moment, experts say P2P software simply is not robust enough to handle complicated business transactions. But the infrastructure is finally being put into place — and the potential for true disintermediation is absolutely mind-boggling. Some champions of peer-to-peer networking believe the switch to serverless computing will radically transform supply-chain management, procurement, billing, and scores of back-office functions.

At the very least, P2P B2B probably sounds the death knell for scores of electronic trading hubs. While some online exchanges will survive, many will serve no purpose once companies can conduct secure, private transactions over P2P sites called peering portals. In a recent article in the Harvard Business Review, Andrew McAfee, an assistant professor at Harvard Business School, wrote: “Together, the peering portals of all the companies on a network will create a universal catalogue of product and service offerings.” —John Goff